Easing IHT burdens with regular gifts

Karen Barretto goes through the benefits to be gained by gifting out of normal income

The current economic climate has left many people uncertain about the future and advisers have found that some clients have been reluctant to commit lump sums to estate planning products.

One alternative to single lump sum planning is gifting on a regular basis using an often overlooked exemption known as 'gifting out of normal income'. This exemption allows an individual to gift small or large amounts of their surplus income without incurring any charge to inheritance tax nor indeed affecting their nil rate band.

The sum gifted must be from surplus income, for example salary, investment income or pension and must not reduce the donor's standard of living.

This is arguably one of the most useful of the IHT exemptions and the relevant legislation can be found in section 21 of the Inheritance Tax Act 1984 which exempts a transfer if, taking one year with another, it can be shown that it was made out of income and that, after the gift, the donor had sufficient net income to keep up his usual standard of living.

The case of Bennett and others v CIR provided a useful framework for utilising this exemption and lays out the general guidelines as to how this exemption applies:

- 'normal expenditure' must be part of the settled pattern of expenditure adopted by the donor;

- a 'settled pattern' can be shown from the expenditure of the donor over a period of time or by showing that the donor assumed a commitment or adopted a firm resolution, in relation to future expenditure and has then made gifts in accordance with that commitment;

- there is no fixed minimum period to establish the relief;

- where there is no formal commitment or resolution, it may be necessary to show a series of payments (three will usually suffice, two possibly);

- there can be some variation in the pattern, but to claim the relief it must be shown that the donor intended a pattern to exist and to remain for a period of time (barring unforeseen circumstances);

- the amount of the transfer does not have to be fixed; the amount may not be to the same person each time; the amount may be fixed by a formula such as a percentage of earnings or a figure such as 'what is left over after paying nursing home fees';

- tax planning does not disqualify the expenditure: almost the reverse; if the taxpayer can show that he entered into a series of gifts having taken advice, and intending to make use of the relief in s.21 IHTA 1984, it will help that he took the advice in claiming the relief.

It is important to note that the capital element of a purchased life annuity or withdrawals from an investment bond will not satisfy the income test. Additionally, if the withdrawal from the bond is used to replace income to maintain the standard of living, the exemption would again not be available.

The use of this exemption works well for the client looking to make provision for children or grandchildren, in particular when making a provision for the funding of school or university fees.

As long as the criteria above is adhered to gifts can be made into a discretionary trust or outright (assuming the recipient is over 18).

If we take the example of Mrs Jones, married with two adult children and two grandchildren aged seven and 11. She has worked throughout her life and just finished paying off her mortgage which has reduced her monthly outgoings. She is in receipt of a generous pension and other investment income, which for the year will total in excess of £80,000. This has left her in a very comfortable position and she has now decided it would be an appropriate time to put money aside which could be used to help fund her grandchildren's education, especially as the family hope that they will both attend university.

In conjunction with her financial adviser a comprehensive financial review has been undertaken. This has established that in order to maintain her current standard of living, taking into account her normal outgoings, expenditure and her annual holiday abroad, she requires in the region of £45,000 per annum.

This leaves Mrs Jones with a surplus of approximately £35,000 per annum. Her financial adviser has suggested that a good use of a portion of this surplus income could be to gift part of it into a discretionary trust for the benefit of her two grandchildren, utilising the 'gifts out of normal income exemption' for the reasons already outlined in this article.

The transfer into the discretionary trust will be exempt for IHT purposes. Normally such transfers would constitute chargeable lifetime transfers.

Adopting a cautious approach the financial adviser has suggested that Mrs Jones may wish to gift £10,000 pa into the discretionary trust. In order to retain an element of control over the gift she could name herself and her children as trustees. A discretionary trust has been chosen as it offers several benefits which appeal to the client:

- It provides maximum flexibility.

- Offers trustees complete control over the trust fund and its investment strategy

- The trustees are given wide discretionary powers as to when, how much and to which beneficiaries they should distribute the income and capital of the trust.

- Can prove useful where at the time of creation of the trust the future needs of beneficiaries cannot be accurately determined.

- Can allow for future beneficiaries to be added as appropriate.

It should be borne in mind, however, that while the exemption can provide a tax free way into the trust for the settlor, Mrs Jones, the trust itself will be subject to a periodic charge, of between 0% and 6%, every 10 years based on the value of the trust fund if over and above the available nil rate band and potential exit charges. The taxation of a discretionary trust is outside the scope of this article.

Recalling the criteria in Bennett and others v CIR, that the amount of the transfer does not need to be fixed, the financial adviser has therefore set up a series of annual meetings to review Mrs Jones's circumstances and the availability of surplus income for each year.

The financial adviser has also recommended the use of a regular premium savings policy, offered by an offshore life company, as the underlying investment for the trust. This has several benefits namely:

- It is a non income producing asset which will keep the trustee's administration to a minimum.

- As an offshore investment it can provide the potential for greater investment returns through the effect of gross roll-up.

- 5% tax deferred withdrawals which, among other things, can be utilised for payment of school fees.

- Offshore investments tend to offer a wider range of funds to invest in.

- Finally, record keeping and HM Revenue and Customs reporting requirements.

As with all types of planning, especially inheritance tax, it is important that up to date records are kept. In relation to gifting out of surplus income, new regulations were introduced in February 2008 concerning 'lifetime' reporting of gifts. Prior to this, gifts only needed to be reported on death.

Lifetime reporting requirements

The rules vary depending on the nature of the gift. In order to determine whether a report is required, the donor needs to add together any gifts made under this exemption in the preceding seven years with any chargeable lifetime transfers made in the same seven year period. If the total exceeds the donor nil rate band, a report is required using form IHT100.

HMRC will review the exemption at this time to confirm it meets the requirements and confirm their conclusion in writing.

The HMRC Inheritance Tax Manual sets out its approach to such claims and more detail can be found on the HMRC website.

Reports on death

The executors of the deceased's estate will need to include a claim that gifts should be treated as exempt as 'gifts out of income' on the form IHT400 and IHT403. These forms have been introduced to replace the forms IHT200, D3 and D3a, which are being phased out and cannot be used after June 2009.

It is essential that adequate records are kept and maintained on a regular basis and these forms should be completed at least annually as part of a continuing review of the client's circumstances.

In conclusion, as one can see from the example given, this exemption is an extremely valuable one, as it does not interfere with any exemptions or reliefs for inheritance tax. It can allow a client some control, within the guidelines, over the amounts of income gifted without having to commit to giving large portions of available capital while at the same time reducing their inheritance tax estate.